Tough Times for ETF and ETN Providers

Currency Investing: Rolex Arbitrage and Blood in the Streets

For the first half of last year, it looked as if 2008 was going to be the year of the currency market. New currency ETFs and ETNs were introduced just about every month, and the lists of SEC filings for new offerings grew longer each time you looked.

Much of the inspiration for new filings came from the high growth in assets under management from the few established currency ETF providers, Rydex Investments, and, later, Wisdom Tree. Growth in the new asset class clearly outpaced more conventional ETF growth, and major new players declared an interest in currency markets. It looked as if there would be strong competition with the few established players that had earlier staked their claims.

Then, in July and August, the currency world was turned on its head when the long-suffering U.S. dollar began a recovery. The graph below shows the euro /dollar over the last eight years. The recovery of the dollar is clearly seen in late 2008. Although the chart shows only the euro/dollar pair, the shape of the graph is similar for almost every other currency of the world's largest trading countries. It was a tectonic shift in currency trading, made much worse by the world-wide recession that was already in the making but then was largely invisible to investors.

click to enlarge

The relationship between the current recession and the dollar's recovery is not 100% clear to me. Many economists and currency traders had been predicting a dollar turnaround in 2008 and many had forecast a mild recession. I wrote several articles in late 2007 and early 2008 about a pending recession. But I had not tied these two events together. My own projections of a dollar turnaround were based on the exceptionally low valuation of the dollar, which showed that the purchasing parity concept of dollars with most other currencies was clearly violated.

By 2008, the downward correction had gone too far, and it became ridiculous: when French tourists could fly to Miami, pay for Rolex Watches with dollars, return to Paris, and sell them at twice the price in euros, one knows that there is a disparity between the currencies. When arbitrage reaches the Rolex market, the dollar is too cheap.

It is now clear that once the worldwide recession began, and economies all over the globe headed for the cellar, there was a predictable flight to the safety of U.S. Treasury debt. As investors sold off their emerging market and other foreign debt, they put the proceeds into U.S. Treasury obligations. The outflow from foreign bonds was so great that they bid the price of Treasuries up and drove the yield on short Treasuries down to near zero levels. Buying Treasuries requires purchases of dollars, so the dollar surged as capital flight found its way to American fixed income markets.

Foreign currencies fell, and they kept falling. Before the carnage was through, drops of 25%, 35%, 45%, and more were registered in major trading partners. The chart below shows the yen ETF, (FXY), euro (FXE), Brazilian real (BZF), the Australian dollar (FXA) and the Mexican peso (FXM). Only the yen has proved a winner since the fall began.

We are, of course, still in the grip of the world recession, and the currency markets have yet to begin anything resembling a recovery. I would not expect a sustainable recovery until the financial markets in the large trading centers get their sea-legs beneath them once again.

In one sense, this must wait until the United States and the U.K., where the banking systems are broken, get their financial systems functional and solvent. The repercussions of these colossal failures are still ripping through financial markets on every continent. World trade is contracting and looks to continue doing so until some force greater than I can see reinstates a sense of order in the world's economies.

The effects of the world recession have pervaded everything in the world of commerce. But, my focus now is not how it affected international markets, but how it has affected currency trading with American ETFs and ETNs.

There is one outright casualty that is apparent from the table below. Assets under management of every major provider of ETFs and ETN have suffered. But the worst casualty is seen by the absence of the Elements brand of ETNs. This brand ceased trading on American exchanges on November 17^th of last year. Their demise was the first currency ETN provider casualty of the global slowdown. It was the result of a poor design by Merrill Lynch and Deutsche Bank (DB), who collaborated on the Elements brand.

Assets Under Management for Five Currency Providers

The survivors also took a hit. As the table above shows, the average loss in assets under management was almost 43% from July 31^st to Early February of this year. The distribution of losses is interesting. The two providers who suffered the least are Van Eck and PowerShares. Both these firms have short and long currency instruments among their offerings, and the short side has shown good growth.

The dollar up/down funds by PowerShares (UUP), (UDN) gives investors a chance to play either side of the dollar against a bundle of currencies of our major trading partners. For now, the dollar bullish fund has between two and three times the assets of the dollar down fund.

Similarly for Van Eck, their double down euro (DRR) has saved the day for them. They also offer a double up (URR) euro, and both funds have actually grown since July 31^st of 2008. Their growth has more than made up for the loss of assets from their Chinese Renminbi (CNY) and Indian Rupee (INR) funds that were introduced last year.

Another apparent loss to currency investors is that many new currency pairs that were scheduled to come to market before the end of last year have quietly been put on hold. There is a long list of currencies that were scheduled to come to market by the end of 2008: Currencies of Hong Kong, Hungary, Poland, and Turkey were readied for their prime time introduction, but were not offered. Perhaps they will be brought to market later, when the industry settles down.

The last casualty of the recent carnage is the carry trade. When world trading volumes recover, and when the currencies of the emerging markets stabilize, the carry trade may be able to make a comeback. But, as of now, with an extreme volatility that characterizes all emerging market currencies, the carry trade is virtually dead. It will probably stay that way for some time. Rational players in the carry trade cannot handle excessive volatility in their target currency. Almost a decade of a falling dollar made the carry trade easy. The recovery of the dollar made it impossible.

I do not believe that exchange traded currency investing will itself be killed off by the current economic turmoil, but the providers have hemorrhaged assets at an alarming rate. I wonder if the smaller providers will continue with their offerings with this much blood on the streets.

It is said that hard times make us stronger. I hope this is the way it plays out. I'm ready for a little strength. And I am certain that the American currency ETF and ETN providers will welcome the day they can face their boards of directors and report strong sales and high profits again. But, until better days arrive, the providers and cautious investors can only hunker down and wait for the storm to blow itself out. For professional traders and those with a large appetite for risks, there are plenty of risks to be taken, long or short. But the industry that provides the vehicles than enable trading of this type, has little to cheer about for now.

Comments

[Phil Bak:]

The dollar got hammered during the bull years of 2002-2006, I dont see the dollar strength now as a surprise. I havent been able to define an inverse relationship between US equities and US dollar, but there is no positive correlation.

Also, the "dollar strength" is expressed in relative terms; its not like Euro countries are doing well.

Feb 12 10:20 AM

[skopros:]

one burning question seems to me is: are the depositories of assets backing ETFs or ETNs a safe bet, when banks seem to creaking and cracking on the edge of a precipice. Is there any danger of a Barclays or JPM going over the edge--and taking the supposed underlying assets with them. it's an argument (or query) similar to rumors that funds such as GLD don't really have the physical gold to back their liabilities to shareholders if something blows up.

i'm finding it hard to get any real answers...maye i'm not asking the right questions. advice appreciated.

Feb 12 04:37 PM

[Ray Hendon:]

Any ETF that is registered under The Investment Company Act of 1940 is free from any of the shenanigans that the banking industry and others used to fleece investors. These trusts are rigorously regulated and, as importantly, their monies held and securities purchased must be held by separate companies under highly controlled conditions. All of WisdomTree's currency assets are registered under the provision of this act, and, I believe, so are PowerShares. You might the prospectuses for more details on this provision.

ETNs are a different matter. With these instruments the safety is dependent entirely on the credit worthiness of the ETN provider at the time the fund matures. Personally, I do not like the ETN format. It has so many things wrong about it that I can't bring myself or any of my clients to risk a penny in their trust. Not everyone agrees with me harsh assessment, but I stand by it. Why take a credit risk that is added to the market risks you are already taking?

Best wishes,

Ray

Feb 12 09:33 PM